How to avoid investing with a “Madoff”

Written By: Jason Shafrin
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Dec•
23•08

Bernard Madoff operated one of the biggest Ponzi schemes in history. He has not only defrauded rich investors, but charities and university endowments as well. If smart, Wall-street types were fooled by Madoff, can you realistic expect to avoid these Ponzi schemes? It may surprise you but the answer is YES.

If you are a loyal reader of this blog, you know that I am a huge advocate of index fund investing (seetheseposts). I have tauted the low expense ratios and diversification benefits of index funds. Now, there is one additional benefit: transparency.

If you invest in an S&P 500 Index Fund at Vanguard, you are fairly certain that the fund’s performance will track very closely (within 1-2 percentage points) of the underlying index. If you see the S&P 500 drop 30% in a year, and your stock broker claims that you have made a 10% positive return, you know to be suspect. Similarly, if you buy a small cap index fund and small caps rose by 20%, but your fund only went up by 5%, you should be suspect of the returns as well.

Thus, by investing in index funds, you can validate whether or not your returns seem reasonable by comparing them to the underlying benchmark indices.